Question

The Spread of Government Deposit Insurance Throughout the World: Is This a Good Thing? For the first 30 years after federal deposit insurance was established in the United States, only six countries emulated the United States and adopted deposit insurance. However, this began to change in the late 1960s, with the trend accelerating in the 1990s, when the number of countries adopting deposit insurance topped 70. Government deposit insurance has taken off throughout the world because of growing concern about the health of banking systems, particularly after the increasing number of banking crises in recent years (documented at the end of this chapter). Has this spread of deposit insurance been a good thing? Has it helped improve the performance of the financial system and prevent banking crises? The answer seems to be “no” under many circumstances. Research at the World Bank has found that, on average, the adoption of explicit government deposit insurance is associated with less banking sector stability and a higher incidence of banking crises. * Furthermore, on average, deposit insurance seems to retard financial development. However, these negative effects of deposit insurance occur only in countries with weak institutional environments: an absence of rule of law, ineffective regulation and supervision of the financial sector, and high corruption. This situation is exactly what might be expected because, as we will see later in this chapter, a strong institutional environment is needed to limit the moral hazard incentives for banks to engage in the excessively risky behavior encouraged by deposit insurance. The problem is that development of a strong institutional environment may be very difficult to achieve in many emerging market countries. We are left with the following conclusion: Adoption of deposit insurance may be exactly the wrong medicine for promoting stability and efficiency of banking systems in emerging market countries.

Discuss the positive and negative impacts of this type of insurance.

Answer 1

Positive and Negative impacts

Positive

Advantages to Individuals

The biggest advantage of deposit insurance to individuals is the peace of mind in knowing that their deposits are not going to become inaccessible if their bank becomes illiquid or insolvent. This means that people are more inclined to put money into their bank rather into other investments or under their bed.

It also helps people on a society-wide basis. If more people put money into the bank, then the bank has more funds to access. This means it has more funds to lend, which in turn lowers interest rates. So, if a private individual wants to get a loan to build an addition on his kitchen, he has the FDIC to thank (at least in part) for his low-interest loan.

Advantages to Banks

Banks, like all businesses, cannot function without an influx of cash. They get this cash from people lending them money at low interest rates in the form of savings and checking accounts. If people lost faith in banks, they would put their money elsewhere, buying commodities, investing in property or simply hanging onto cash. This would render banks insolvent and they would go out of business.

Banks also benefit from the protection that deposit insurance offers. If they make too many bad investments, or leverage themselves too much and end up failing, they do not necessarily go bankrupt. Instead, the FDIC will take them over and put them under new management. Leaders lose control of their bank, but they do not go completely bankrupt as they might without deposit insurance.

Control

When the FDIC assumes control of failed banks, it protects the consumer as well. The FDIC will pay up to $250,000 out of its own budget to each depositor. However, this does not mean that depositors will automatically lose anything beyond $250,000.

When a bank fails, the FDIC's first move is transfer ownership to a bank that is more financially solvent and able to take on the failed bank's debts. If this is impossible, then the FDIC sells off the failed bank's assets to whoever will pay for them, in an attempt to recover enough to allow all depositors to be paid the full value of their accounts. Finally, if this does not work, the FDIC will pay up to $250,000 to each depositor out of its own budget, then attempt to make up shortfalls out of the sale of the failed bank's assets.

The $250,000 figure is how much the FDIC is prepared to spend on each depositor, but it can usually regain their assets without spending this much. The first option listed above—yielding control of failed banks to solvent banks—is effective in the majority of cases.

The advantage of deposit insurance is clear: it did stop bank runs with the resulting bank failures, and gave people a greater confidence in the financial system. In 1934, the 1^st full year that deposit insurance was in force nationwide, only 9 banks failed compared to the 9,000 that failed in the preceding 4 years.

Negative

However, many people also think that deposit insurance has its disadvantages. Many have argued that since so few banks have failed over the years, especially in the 1950's and 60's that deposit insurance is propping up mismanaged and uncompetitive banks. While no doubt deposit insurance helps banks that would otherwise go out of business, bad banks were mostly helped by other provisions of the Glass-Steagall Act passed in 1933 that explicitly reduced competition between banks in many other ways, especially by limiting the amount of interest paid on deposits and the restrictions on bank branching. A number of new laws have increased competition between banks, especially in 1980, when the Depository Institutions Deregulation and Monetary Control Act of 1980 was passed, and in 1999, when the Financial Services Modernization Act of 1999 was passed. Since then, bank failures have greatly increased even though deposit insurance is still in effect.

Another disadvantage often argued is that deposit insurance causes moral hazard that motivates bank managers to take bigger risks because their depositors are insured. But banks always had moral hazard because they earned profits using other people's money—whether it was the depositors', money that banks borrowed, or stockholders' money. For instance, many bank managers in the 1800's took large risks even when their banks were not covered by deposit insurance because it was not their money at stake, but they would reap the profits, and, naturally, many of them failed.

Another big cause of moral hazard in banking besides using other people's money is the too-big-to-fail policy. The recent credit crisis is a good example in which governments around the world were forced to bail out their banks with trillions of dollars to prevent them from collapsing because they made bad loans and bought or insured bad assets based on those loans. Bank managers took outsized risks to make big profits because they considered themselves too big to fail—in other words, if their failure were imminent, the government would be forced to bail them out. Of course, they were right, because that is what happened.

Unfortunately, the too-big-to-fail policy is probably necessary, since the failure of large banks with their interconnections would cause a contraction of the money supply, devastating the economy. Hence, governments will almost always be forced to bail out large banks when necessary. The solution to this problem is strict regulations and bank supervision.